Ron Baron Second Quarter 2014 Shareholder Letter

“This company could survive for a long time without its CEO. It couldn’t last through lunchtime without its welders.” Mogens Bay. Chairman and CEO. Valmont. May 2014.

On average, three to four corporate management teams visit us every day. Management meetings provide us with context about businesses that we research and in which we invest. These meetings also enable us to ask questions about long-term strategies, growth opportunities, challenges and competitive advantages. As importantly, they give us a chance to qualitatively assess management talent and personalities. That may be what is most important of all and in keeping with our mission statement, “we invest in people.”

A large part of stock market volume is comprised of short-term traders who own stocks for a few months, weeks, days, seconds, milli-seconds or nano-seconds. Accordingly, we get managements’ rapt attention when we tell them we manage $26.8 billion; our firm has an average investment holding period of six to seven years; and, our largest fund, $8.3 billion Baron Growth Fund, invests in businesses for on average nine years! What we think deserves the attention of Baron Funds’ shareholders is not only that we invest for the long term, but that over the long term, Baron Funds have performed better than the benchmark indexes against which we are compared. You can see this from the performance charts on pages 10-14 immediately following the “Letter from Linda.”

I nearly always find something relevant and memorable in management meetings I attend, whether in our office or theirs. A recent visit by Mogens Bay, Chairman and CEO of Valmont (VMI), a diversified industrial company, is a case in point. We have had a modest sized investment in Valmont since 2009. We have since about doubled our money.

We think Valmont’s towers business will benefit from increased spending by utilities on more efficient electricity transmission and is well-positioned to grow. This is because the Federal Energy Regulatory Commission, in order to reduce our country’s energy consumption, has granted utilities significant incentives to invest in transmission.

We believe Valmont’s world leading irrigation business is also exceptionally attractive and poised for growth. With the world’s population expected to increase 30% by 2050, there will be increased demand for food. The world cannot meet its crop requirements without irrigation. This is because irrigated farmland provides better yields. Only 20% of cultivated agriculture worldwide is irrigated. Center pivot irrigation uses the least water, a scarce resource, and produces the best yields. Valmont has a 45% share of center pivot irrigation systems in North America and is increasing its share in the rest of the world. Center pivot irrigation has also been steadily increasing its current 56% share of irrigation.

When Mogens visited us recently to provide an update, he mentioned that he tries to visit all of his firm’s more than 100 worldwide plants regularly. When he does, he always talks to his factory workers. When I asked whether he has prepared remarks or speaks from the heart, he told us it was the latter. He explained that “the culture of a business is what’s important.” He said that he wants his general managers to be entrepreneurs “who are passionate about what we do…make highways safer, protect the environment, don’t cut corners and commit to continuous improvement.” Mogens went on to say “with plants around the world, somewhere someone is doing something wrong.” He finds ‘Can I show you what I do?’ an effective way to communicate and train. “You need to look yourself in the mirror every day and make sure you don’t need to look down. It’s all about how you treat your employees and customers. How you expect people to behave.” Mogens then remarked that “you need to show people that you respect them and care about them.” To make that point, he frequently tells his fellow employees that Valmont “could survive for a long time without its CEO. It couldn’t last through lunchtime without its welders.”

Valmont’s home office is in Omaha, Nebraska. Omaha also happens to be the home of the world’s most prominent investor. When Mogens finished updating us, I remarked that “there must be something in the water” in Omaha. Mogens is an individual I think about when I tell our investors that “we invest in people.” It’s too bad we don’t have a larger investment in his business, I thought. It’s also too bad we didn’t invest earlier. If we had invested in 1993, we would have earned 16.6% compounded annual growth for the past 21 years. The S&P 500 Index earned a compounded annual return over the same period of 9.4% per year.

During my 44 year investment career, I have known many brilliant investors, analysts and regulators. I have not met any, however, able to consistently predict how stock markets will perform. For example, in 1996, then Fed Chairman Alan Greenspan thought stock prices were “irrationally exuberant.” The Dow Jones Industrial Average was then 6,000. Highly regarded Yale economics Professor Irving Fisher in the autumn of 1929, shortly before the market crashed, thought “stock prices have reached what looks like a permanently high plateau.” Many institutional and individual investors today agree with Professor Stiglitz’s view that stocks are expensive. Perhaps influencing their judgment is that they may not have owned stocks as they rebounded from their low point during the Financial Panic that ended in March 2009. They, as a result, continue to hope for a decline to give them another chance.

To provide you with historic perspective on stock valuations, U.S. stock prices have increased less than 26% from their peak levels nearly seven years ago in 2007 and less than 30% from their peak levels in March 2000,over 14 years ago.* In contrast, U.S. stock prices over the past century have doubled about every 10 years. Stock valuations at present approximate 16 times earnings. That is the median level for the past hundred years. Stock prices are based on many factors. Among them are interest rates and our economy’s growth prospects. Interest rates have never been lower in the history of our nation. Low interest rates make stocks more valuable. If investors expected rates to remain at present levels, stock multiples would now be much higher. Further, our economy is steadily growing; unemployment is steadily falling; and our nation is fast becoming energy independent. These are all good things. You can google other stock market predictions by well known investors over the years to see for yourself how accurate they have been.

By contrast, Warren Buffett (Trades, Portfolio), the most successful investor of our time, says that “I have no idea what the stock market is going to do. Not the faintest idea. We are not in that business.” He then remarked that, “If I had known in 1973 what would happen in 1974, I never would have bought stocks in 1973.” Buffett did invest in 1973. The Dow Jones Industrial Average was then under 1000.

The story of my wife’s Aunt Ruth is one, like Buffett’s, that I think also supports an optimistic outlook about long-term investments in publicly-owned businesses.

Ruth Bregman. 1912-1996.

Ruth Bregman was my wife Judy’s aunt. Soon after Judy’s mom Sylvia died in 1982 at age 72, Aunt Ruth, Sylvia’s younger sister by two years, became Judy’s surrogate mom. This spring, Judy’s cousin sent us a 1990 video of Aunt Ruth being interviewed by her two daughters. Aunt Ruth’s dad, Morris Krumholz, emigrated from Austria to America in 1897. He was then 15. He came to America to escape religious persecution. When Morris couldn’t find a job, he lied about his age and in 1898, enlisted in the U.S. Army to fight in the Spanish-American war. His future wife, Ray, came to America from Morris’ home town in Austria in 1898. Soon after the Spanish-American war ended in 1901, the young couple married.

Their first apartment was in a tenement on New York City’s Lower East Side, a community of immigrants. Morris’ first job was as a peddler selling thread to garment factories. When Morris didn’t earn enough as a peddler, he moved Ray and their four daughters to New Jersey where they became chicken farmers. When that didn’t work out either, Morris became a land speculator in Illinois. Finally, in 1923, Morris and his young family returned to New York where he became a builder/owner of six apartment buildings in the Bronx! The family prospered in the 1920s.They did not fare as well in the 1930s. When Morris’ tenants couldn’t afford their $44 per month apartment rents because they had lost their jobs, Morris told them to “pay me when you can.” Further, when his tenants had difficulty buying food for their families, Morris lent them money! When Morris died in 1937 at age 55, four of his six buildings had been mortgaged during the ‘30s and were lost. The rents from the two buildings he owned free and clear were enough to support his family for quite a while.

In 1935, Aunt Ruth married Nat Heyman. Nat’s business sold the U.S. Army buttons for soldiers’ uniforms. His business thrived during World War II, but Nat, just like Aunt Ruth’s dad, died at a young age. In 1951, when Nat, too, passed away, he was only 48. But, by that time, Aunt Ruth had saved $150,000, which she thought would last for the rest of her life. The purchasing power of our currency was a lot more then than now. For example, my parents bought our first single family home in 1948 for $5,000! My dad was an engineer for the Army at Ft. Monmouth, New Jersey, and, in 1956, when we celebrated my bar mitzvah, we also celebrated the first year my dad would earn $10,000!

So…in 1951….$5,000 homes…$10,000 engineer salaries….$44 per month apartment rents…a Dow Jones Industrial Average of 239…and $150,000 cash with more than $1.5 million purchasing power in 2014 dollars!

Sound as a dollar?

Is it any wonder that we take Federal Reserve Chairman Janet Yellen at her word that the Fed will create inflation and won’t raise interest rates abruptly. To foster economic growth, she thinks the benchmark short-term rate is unlikely to rise as high as it has in previous, more robust recoveries. We think Chairman Yellen will continue this policy because our economy remains highly leveraged. Government, corporate and private debt, in the aggregate, represent more than 300% of GDP. If interest costs rise, borrowers will find it difficult to pay interest on their debt while maintaining spending. That could have a substantial negative impact on our economy’s growth rate and ability to create jobs. If interest costs remain less than inflation, our indebtedness will decline as a percentage of our nation’s GDP. Stocks are a hedge against declining currency values and increasing inflation. Investments in growing businesses, we think, are the best hedge.

Baron Funds invests for the long term in competitively advantaged, entrepreneurially managed, growing businesses. Although we believe it is not possible to predict markets in the short term, we think long-term prospects for publicly owned businesses are quite favorable. This is since we think they will continue to double their earnings and their value from present levels about every ten years. That represents a 7% compounded annual growth rate. This is while the purchasing power of our money will continue to fall by half every twenty years. That represents, as has been the case for the past hundred years, about a 3.5% annual decline in the dollar’s purchasing power. As a result, I guess it should not have been surprising that after I watched “The Aunt Ruth Video,” I was so optimistic that I couldn’t sleep…

Increasing life expectancies…another reason to be optimistic…

One more thing. In 1900, as you can see from The Aunt Ruth story, the average life expectancy for United States’ citizens was 48 years. In 2014, it is 80 years! Further, if you are lucky enough to make it to 70 and have a healthy lifestyle, you are likely to live well into your 90s! Science promises us that affordable genome sequencing will soon enable us to determine the causes for more diseases. Also, biotech therapies in the coming age of “personalized medicine” will allow us to prevent and cure presently incurable diseases. Many believe the average person in America can expect to live to 125 before the end of the present century. As one small step, during the 12 years of Michael Bloomberg’s term as New York’s mayor, the average life expectancy for New Yorkers increased three years! According to Julian Robertson (Trades, Portfolio), Founder of Tiger Management Corp., this was the result of our former Mayor’s efforts to improve our city’s environment and educate our city’s residents about healthy lifestyles.

My mom passed away after a brief illness two years ago at age 92. Reaching that age would have been improbable at the beginning of the twentieth century. When my mom died, she had been married to my dad for nearly 70 years! My dad will be 94 in December. Jerry Seinfeld’s mom, Betty, was a good friend of my mom’s, and has an apartment in Florida on the same floor as my parents’. Betty is now 97 and still few can keep up with her vigorous exercise program…regardless of how old they are! Finally, my Uncle Sam piloted airplanes well into his 80s. He too got around pretty well… until he crashed his motorcycle into a truck when he was 85! With exponential advances in technology and health care, we are pretty sure our children and grandchildren will lead happier, healthier and longer lives than we will. Which is another reason for us all to be optimistic.

We hope you will be able to attend our 23rd annual investment conference on November 7. These annual meetings are designed to allow you to meet and question executives of businesses in which your hard-earned savings have been invested. They also give you an opportunity to meet and question our portfolio managers and analysts, Linda and me and our sales representatives about our investment process, our portfolio investments, and any other topics that are on your mind….no questions are off limits. We hope you will regard this day as one to “kick the tires” of your investments in Baron Funds. During dinners on Thursday evening before our conference and the early part of that Friday morning, there are special programs for institutional investors, registered investment advisers, independent financial advisers and consultants. At these dinners and programs, attendees will have a chance to meet and speak one-on-one with our analysts and portfolio managers. Again, no topics are off limits. Our analysts and managers will be available throughout the rest of Friday to answer any questions any of you may have.

Finally, the entertainment. At lunch. At the end of the day. As usual, we think it will be very cool…outstanding, as a matter of fact.

Also, as usual, it will be at our expense, not yours. And as usual, it will be a surprise. No, we can’t tell you who it is. Only Linda and I know for sure. Linda because she signs both the contracts and the checks. Me because I choose the entertainers.

We hope we’ll see you November 7. For those of you who can’t attend, though, you will be able to watch by live webcast from the Baron Funds website everything but the entertainment. (we are contractually prevented from streaming entertainment). You can get a sense of our meeting by watching CNBC’s Squawk Box that morning from 6 AM to 8:30 AM (Eastern Standard Time). Becky Quick and I will be interviewing several executives with whom we have invested and with whom we expect Baron Funds to make a lot more money…although we obviously can’t promise that. I will also be interviewed on Squawk Box by Becky live from the conference that morning.

We like to say that “we invest in people.” We hope when you attend our annual conferences or watch us on CNBC or visit our website, you will gain a better understanding of the businesses in which we invest; and the character and talent of the executives who run them; and the characteristics of the people who work at our Firm. See you in November.

Thank you for joining us as fellow shareholders in Baron Funds. We will continue to work hard to justify your confidence in us. See you this fall.

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